Canadians, in general, have a giant hard-on for real estate.
This is obvious to anyone with a set of eyes and functioning grey matter. Owning a home is a dream for most Canadians, even though prices in our major markets makes this difficult for people earning an average salary. HGTV continues to show reruns of Mike Holmes fixing shoddy renos done by some Mexican picked up in a Home Depot parking lot. And Brad Lamb, in his zeal to become rich enough that he might be able to afford hair implants, continues to point out that the best path to wealth is to buy all the condos.
So yeah, you could say that Canadians are more horny for houses than Nelson watching women’s curling.
Naturally, people were clamoring to be part of this action. Real estate markets across the country did well, including Montreal homes. Besides a blip during the 2009 financial crisis, Canadian real estate has been one of the better performing asset classes. And since most Canadians do own property, the prosperity has been widespread.
Even though Canadian housing prices are at record highs, shares in most REITs are down 20 or 30% from their highs set during the early parts of last year. This coincided quite nicely with threats that the U.S. Fed was going to end Qualitative Easing, which would ultimately make interest rates rise. Investors in REITs care more about distributions than the price of the underlying real estate. A potential in interest rates increasing make other interest bearing investments more attractive (i.e. bonds) causing the sell-off in REITs.
Often, people will recommend against people buying individual rental properties. There are many reasons, including the lack of diversification, the risk of a dirtbag tenant taking all of your profit, the amount of leverage most people require to buy real estate, and the fact that most attractive tenants will not sleep with you in exchange for discounted rent, no matter how slyly you bring up the topic. Don’t ask me how I know this.
The fact is, REITs and buying your own rental properties are pretty loosely related. There are huge differences between the strategies, including risks, the type of assets actually being owned, leverage imposed, and so on. Let’s take a look at some of the differences.
Everybody is quick to point out that owning a single or a handful of rental properties is riskier than owning a REIT that may have thousands of similar units. They’re right, of course, but that argument focuses just on the downside, and largely ignores the upside. As we all know, when the risk pendulum swings more towards the risky side of the equation, returns are likely higher.
But what happens when things go right? As I outlined when I told you to buy assets instead of going to college, it’s very possible for someone to use leverage to own two (admittedly modest) rentals over 4 years, and yes, I’m talking about fully owning them, outright. The return on the original amount invested will easily surpass anything a REIT will give you.
Remember, risk isn’t to be avoided at all costs. Diversification does decrease the risk of catastrophic loss, but nobody ever mentions that it decreases the chance of huge gains as well.
The Benefits of Leverage
It’s really easy for an investor to use a huge amount of leverage to buy real estate. A lot of people buy property with 5% down, meaning they control $20 worth of real estate for every $1 of equity. This can go really badly if values go down, but that’s why you analyze a overall market before you buy into it and buy into markets where you think there’s potential for long term growth.
Meanwhile, it’s not so easy to lever to buy stocks. Probably the easiest way is the Smith maneuver, which my MacBook just autocorrected to the American spelling, so we’re going to go with that. Of course, there’s a certain amount of irony if you use the easy ability to leverage real estate to buy stocks, but you could. Or you can use margin debt, but that’s going to cost you considerably more than borrowing against your house.
It’s much easier to use leverage to buy physical real estate. This can make your returns (oh baby).
Boardwalk (TSX: BEI.UN) owns more than 35,000 different residential units, which is a pretty fancy term for kinda crappy apartments. Proponents of owning Boardwalk’s shares list this as one of the main benefits of owning shares in the REIT over buying your own crappy apartment, since one guy cooking meth is just an inconvenience for some property manager to deal with, rather than a life changing event. But again, that’s just focusing on the downside part of the equation.
It’s like buying an index fund. You’ll never do that bad if you just follow the TSX or the S&P 500, but you’ll never get the outperformance that’s pretty much necessary to retire early. You’re condemning yourself to investment mediocracy, which is all fine and good if you’re looking to be one of those lazy investors. In fact, most people should do this, since they’re not willing to put in the work needed to do anything but pick stocks that they see on Twitter.
Remember, there are a lot of REITs that own commercial and industrial properties, markets which are nothing like most residential markets. So most REITs aren’t even a direct comparison to owning rental properties anyway.
There are many differences between buying physical rental properties than buying REITs. Basically, there are more risks, but there’s also more potential reward. But ultimately, the only thing they have in common is the exposure to real estate. The risk profile is completely different, the skills needed to analyze and manage each type of investment are completely different, and the potential rewards are completely different. So please, stop treating them as an either/or proposition. REITs have more in common with stocks like Rogers Sugar or A&W Restaurants than they do with a landlord owning a few properties.